Why the emerging markets joyride is ending and it’s time for investors to pull back
David Brown says global trade tensions, a stronger US dollar and rising interest rates have hit emerging markets hard
Tensions are rising globally, financial markets are a battleground and emerging markets are back in the firing line. Whether it is the threat of a global trade war, a stronger US dollar, higher borrowing costs or risk aversion on the rise, it is taking its toll on asset allocation as investors take fright on emerging market trades.
With question marks already raised about the end of the road for the global equity rally, investors are pulling in their horns and peripheral trades like emerging markets are feeling the strain.
Ever since US President Donald Trump fired the first shots in his growing trade dispute with China and Europe, emerging markets have felt profound shock waves. These markets are deeply dependent on buoyant world trade, so anything which casts doubt on the future health of global growth is bound to go down like a lead balloon. Investors are suddenly losing faith in the “Goldilocks” formula of low interest rates, benign inflation, brisk growth and a never-ending stock market bonanza.
Market confidence will progressively worsen the longer the uncertainty persists over Trump’s trade policy intentions. In the worst-case scenario, the present crisis could end up a precursor to a full-blown trade war. Selective tit-for-tat measures between the US and its trade competitors are one thing, but the imposition of sweeping, wholesale sanctions would be a massive game-changer. Emerging markets risk being crushed in the middle.
Emerging markets have enjoyed a joyride in the past few years as global growth rallied in response to highly expansionary monetary policies in the major economies. A decade of near-zero interest rates and all the loose money generated by quantitative easing programmes in North America, Europe and Japan have been a once-in-a-lifetime boon for emerging markets as world trade growth bounced back from extremely depressed levels after the 2008 crash.
Emerging markets have piggybacked off a global trade revival which saw annual growth in world export values bouncing back by as much 13 per cent year-on-year by the end of 2017.
The flood of cheap money generated by global super stimulus cooked up a sumptuous economic recovery, but also channelled a wave of buying into higher risk-return emerging market trades, with investors encouraged by better-looking fundamentals, amid much-improved risk-taking conditions in 2016 and 2017.
But optimism has come crashing back to Earth thanks to Trump’s hawkish sabre-rattling on trade and growing geopolitical fears, not least worries about US brinkmanship over North Korea’s nuclear threat. That particular spat is not over yet. Emerging market investment flows are confidence-driven so it is no surprise that emerging market share values have dived by 16 per cent since the start of 2018. Global investors are now battening down on unnecessary risk.
Investors have much to weigh up in the coming months. Quite apart from the specific risks affecting individual markets, there is a welter of systemic problems to deal with, too. Recent rumours that Trump is considering quitting the World Trade Organisation hardly soothe fears about the fallout of his “America first” strategy. If this marks the thin end of the wedge, global economic and investor confidence are due for an even harder shock.
US trade policies are one part of the negative equation building for emerging markets. The other main danger is the US Federal Reserve’s drive towards tougher monetary policy, driving up perceptions of global borrowing costs and the US dollar in the process. Higher US interest rates and bond yields add more pressure to emerging market debt servicing costs, while the stronger dollar intensifies stronger inflation fears as local currencies weaken.
Credit concerns, trade tensions, global monetary conditions and risk aversion must weigh heavily on emerging market flows in the future. If investors start to panic, the impact on emerging market financial stability could be lethal.
The unwinding of high-yield, leveraged carry trades could unfold very quickly. US mutual fund exposure to emerging risk assets remains close to historic highs and could quickly implode. Investors from Europe and Japan would follow suit, compounding the sell-off.
World stock markets have just notched up their worst first-half performance since 2010, so this is no time for investors to gamble any more than they should. The bears are back with a vengeance and emerging market investors should take preventive measures.
David Brown is chief executive of New View Economics